Inflation and money supply in Iran: a closer look
Last week, in a post on the Lobelog.com I noted further signs of moderating inflation. Prices in the Iranian month of Dey (ending 20 January 2013) rose by 1.7%, compared to 2.5% the month before and 4.5% per month in the previous two months after devaluation. These are high rates of inflation on an annual basis (see chart below), but a sign that the Central Bank may have found a way to keep the growth of money supply below the rate of inflation. I was curious enough if this were the case to look up money supply data published by the Central Bank and here is what I found. For the quarter that ended on December 20, 2012, which covers the three month period after devaluation, the rate of growth of money supply was 20 percentage points below the rate of inflation.
The reason why this is noteworthy is because it indicates that large devaluations are not necessarily followed by runaway inflation. In a non-oil exporting country, it would have been very difficult for the government to keep money supply growth this far below inflation if its currency were to lose half of its value. But thanks to oil income, the Iranian government did not have to print money as fast as the currency was losing value after last October’s devaluation. It chose instead to sell a significant part of its currency at lower rates, which is to say that it decided not to monetize its foreign exchange reserves at the free market exchange rate. Thus oil income helped keep the growth of money supply from exploding. It was missing this point that led to the widespread speculation about hyperinflation.
The charts below show how erratic the growth rates of money supply and CPI have been in recent years. The annualized inflation rates in Figure 1 show clearly the impact of three separate events on inflation (marked by vertical lines) — subsidy reform in December 2010, US financial sanctions in December 2011, and the collapse of the rial in October 2012. Each time prices spike but then they resume their normal pace of growth.
Putting inflation and growth of liquidity together in the second chart you notice that money supply, too, spiked after the first two events (2010Q4 and 2011Q4) but it did not after the devaluation shock. This time, the Central Bank seems to have put more emphasis controlling inflation. It chose to keep the growth of money supply steady, though not contracting, at about 32% per year. Those who blame inflation in 2013 on subsidy reform two years earlier should take a close look at how money supply and prices have behaved after 2010. The impact of subsidy reform on prices had largely dissipated by the end of 2010 when sanctions struck.
Figure 1. Annualized rates of inflation based on monthly CPI data (Source: The Central Bank of Iran).
Figure 2. Liquidity and inflation based on quarterly data (Source: The Central Bank of Iran).
If you want to trace inflation further back to 2008, when the Great Recession in the industrialized world began and oil prices fell to $40 per barrel, follow the charts in Figure 2. The chart to the left in this figure shows the annual rates of growth of liquidity (M2) and the CPI (inflation), and the one to the right shows the levels of these variables. The first burst in money supply came in the last quarter of 2008, when the Great Recession hit Iran in the form of lost oil revenue, to which the government reacted by expanding money supply. At this time, inflation was still below 10% per year, and would take a full two years of expansion well ahead of inflation before the subsidy reform would push prices up.
This chart marks the four critical events since 2008 (oil price collapse, subsidy reform, US financial sanctions, and devaluation) and shows that after each event, money supply increased, except for the last one. It shows clearly that the high inflation that afflicted the economy in 2011-12 had its origins in earlier years. The mounting pressures on prices accumulating since late 2008 were suppressed by large inflows of foreign exchange that kept the rial highly overvalued. This is what I have elsewhere referred to as suppressed inflation, which devaluation unleashed. (Incidentally, if you want to see how silly some of the recent discussions about Iran’s economy have been, compare the money supply depicted in these charts with this strange graph of Iran’s money supply).
How long Iran’s monetary authorities will be able to hold the line on money supply is anybody’s guess. With mounting challenges to Ahmadinejad power, the Central Bank may be able to act independently enough to prevent more government spending from further destabilizing the economy. But, with serious talk this week of giving every Iranian 200,000 toomans (about $130 PPP) this March as a Nowruz gift, and inflation seemingly under control, chances are good that the parliament would authorize Mr. Ahmadinejad’s last populist injection of money into the economy.